REAL ESTATE BLOG -- NATHAN A. FELKER

New Ohio law bans some 'bad boy' provisions of certain commercial loans

Blog Entry: April 08, 2013 4:30 AM | Author: NATHAN A. FELKER

NATHAN A. FELKERNathan A. Felker is a partner with the Real Estate Practice Group of Walter | Haverfield LLP in Cleveland.

Earlier this year, the Ohio General Assembly passed House Bill 479 adopting the Ohio “Legacy Trust Act” which became effective on March 27. The new law contains a number of provisions intended to increase the level of asset protection afforded to parties against creditors in the State of Ohio. One such protection is a prohibition against certain provisions (known as “Cherryland” insolvency covenants) in nonrecourse loans secured by real estate located in the state of Ohio that would make the borrower or guarantors of the loans fully liable for the debt as a result of a borrower's failure to remain solvent or failure to pay its debts when due.

A nonrecourse loan is a loan secured by a mortgage on commercial real estate, where the borrower's liability for repayment of the debt is limited to the borrower's interest in the mortgaged real estate, and the lender agrees not to pursue the borrower personally or the borrower's other assets for repayment of the debt obligation.

Nonrecourse loans are common in commercial real estate financing provided by life insurance companies and commercial lenders that sell the loans into the commercial mortgage backed securities market. In a typical nonrecourse loan, the individuals that are the owners of the entity that owns the real estate execute what is known as a “bad boy” guaranty, whereby the guarantors agree to be liable for the entire indebtedness owed to the lender upon the occurrence of certain events. These events may include fraud or the bankruptcy or insolvency of the borrower, among others.

The provisions of the Ohio Legacy Trust Act specifically state that a “postclosing solvency covenant shall not be used, directly or indirectly, as a nonrecourse carveout or as the basis for any claim or action against a borrower or any guarantor of a nonrecourse loan” and that a provision in the documents for a nonrecourse loan that contains any such covenant is invalid and unenforceable.

New protection still has limitations

Note, however, that this only applies to commercial loans secured by a mortgage on real property located in Ohio that limit the borrower's liability for the debt obligation to the borrower's interest in the mortgaged property, and not to other loans that contain no such limitation on the liability of the borrower. It is also important to note that a solvency covenant” is defined in the act as any provision of the loan documents for a nonrecourse loan that relates solely to the solvency of the borrower, including, without limitation, a requirement that the borrower maintain adequate capital or have the ability to pay its debts, at any time after the initial loan funding. The act does not prohibit the lender from making the borrower or guarantors fully liable for the debt obligation based on the borrower's voluntary bankruptcy or other voluntary insolvency proceeding or the borrower's collusion in an involuntary bankruptcy proceeding.

The Legacy Trust Act and its prohibition against the springing recourse for “Cherryland” insolvency covenants definitely benefits borrowers and guarantors of nonrecourse loans secured by real estate located in Ohio. However, many nonrecourse loans are made by financial institutions located outside of Ohio. Consequently, the loan documents often contain provisions indicating that the law of a state other than Ohio will apply to the interpretation of the rights and obligations under the documents. With the Ohio legislature's stated intent that the new law applies to any commercial loan secured by real estate located in Ohio, we will have to see how Ohio Courts sort this out if a lender seeks collection of a nonrecourse loan covered by the Legacy Trust Act from a borrower or guarantor located in Ohio, but the loan documents specify the law of another State that does not have the same sort of prohibition against “Cherryland” insolvency covenants now provided under Ohio.

Nathan A. Felker is a partner with the Real Estate Practice Group of Walter | Haverfield LLP in Cleveland.

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